Tax considerations are an important factor in long-term investing, whether the goal is preparing for retirement or maximizing a charitable giving legacy. That said, investors also need to be careful not to "let the tax tail wag the investment dog."
The choice of investment vehicle and its standing under the Internal Revenue Code should not come before considerations about risk tolerance, diversification and other key asset allocation principles. Yes, taxation matters in a retirement portfolio, but focusing singularly on that issue misses the bigger picture.
This dynamic is explored by financial planning experts Jeff Levine and Ed Slott in the latest episode of their podcast series, "The Great Retirement Debate." During the episode, Levine and Slott consider the benefits and downsides of investing in traditional versus Roth individual retirement accounts, concluding that both vehicles have their virtues and downsides.
"You should not be determining your investments by the type of account you have," Levine said. "First, you should be determining what investments you want and then figuring out where to place them — in what type of account."
As the pair explain, there are some ways in which investors with certain long-term goals can better use one account type or another — but that doesn't make one account "better" or "worse." Rather, it's important to clearly identify goals and understand how the nuances of each account structure can be taken advantage of in pursuit of those goals.
Considerations for Growth Seekers
Levine and Slott point to the example of a younger retirement investor who has the philosophy of "high risk for high reward." On one hand, Slott observed, such investors may be drawn to putting their riskiest assets in the Roth structure.
"You might want those investments in the Roth if you think they are going to take off down the line — because all that gain is going to be tax free in the future when its drawn as income," Slott said. "That makes sense, but there's also a case to be made for the traditional account."
If the high-risk strategy ends up crashing because investors took too much risk at the wrong time, they might wish the investment was in a traditional IRA. Why? Because the government will essentially be "sharing the pain," Slott says.
"There's no question about that," Levine agreed. "The Roth gives you higher reward [in the income phase], but there's also higher risk, because it's effectively all your money. With the traditional IRA, you are sharing that risk, in the sense that, if you had a million dollars in a traditional IRA, part of that is owed to the government in the form of unpaid taxes."
